When your business engages contractors directly, the tax treatment depends on how the individual operates. The two main ways of engaging are:
- Limited Company: Workers operating through a limited company or partnership, referred to as an “intermediary.”
- Sole Traders: Workers contracting in their own name.
Each structure is governed by different legislation, but both rely on the same core legal status tests to determine whether PAYE and National Insurance contributions apply.
The IR35/off-payroll rules apply to engagements involving an intermediary, e.g., limited companies or partnerships. The PAYE Regulations govern engagements involving sole traders.
It is advisable to only allow the use of sole traders where you have a direct engagement.
What is a sole trader direct engagement?
A direct engagement with a sole trader means your organisation contracts directly with the worker rather than through a recruitment agency. Your business is responsible for:
- Determining whether tax rules apply
- Assessing employment status
- Operating PAYE and National Insurance where required
Warning: If a worker is engaged as a sole trader via a recruitment agency, then the agency must apply the Agency Legislation (Chapter 7 ITEPA 2003), which means operating PAYE.
If you engage directly, Chapter 7 need not be considered. You then need to determine tax status.
The method used to determine tax status is largely the same for both limited companies, partnerships and sole traders.
Employment status case law
In both intermediary and sole trader engagements, employment status is determined by established case law stemming from the 1967 Ready Mixed Concrete case. Applying the case law tests is not within the scope of this guide.
Most contractors view umbrella companies as a dealbreaker, not a preference. By sticking to these strict hiring models, you are effectively locking yourself out of the top 40% of the market. This is particularly risky when searching for senior, highly experienced specialists who have the leverage to decline restrictive contracts in favor of "Outside IR35" opportunities elsewhere.
For both structures:
- Both the written contract and working practices are considered
- For IR35/off-payroll, a hypothetical contract needs to be created. Not for sole traders.
- The same legal tests are applied to the contract and factual circumstances.
- The status outcome determines whether the engagement is treated as employment or self-employment for tax purposes.
The subtle differences lie in which legislation is applied.
Exemptions
Unlike IR35, there are no exemptions for firms that hire sole traders. Every engagement needs to be assessed.
For IR35/off-payroll, there is the small companies' exemption. This means that, for a relevant tax year, where a client qualifies as a small company under the Companies Act 2006, the responsibility for applying the off-payroll working rules does not sit with the client. Instead, the intermediary, such as the worker’s limited company, remains responsible for determining the status and accounting for any tax and National Insurance contributions.
Summary & Actions
For direct engagements:
- Where your firm is considered not small for a relevant tax year under IR35/off-payroll, then you need to apply the off-payroll rules.
- For all sole traders, tax status should be assessed and operated correctly.
- In both cases, once the contract has been ascertained, the same employment status case law determines whether PAYE and Class 1 National Insurance contributions apply.
If you are a medium- or large-sized company, anyone hired off-payroll should be assessed.
Technical Notes for Tax Advisors
Direct engagements through intermediaries
Where a worker provides services through an intermediary, such as a limited company or partnership, the relevant legislation for both income tax and National Insurance is:
- Income Tax (Earnings and Pensions) Act 2003
- Social Security Contributions and Benefits Act 1992
- Social Security Contributions (Intermediaries) Regulations 2000
In these cases:
- The client assesses status using employment status case law
- A hypothetical contract is considered between the client and the worker
- If that hypothetical contract reflects employment, the off-payroll rules apply
- Payments to the intermediary are treated as deemed employment income
- The client needs to apply PAYE and NICS (including both employee and employer contributions) to those payments
Direct engagements with sole traders
Where a worker operates as a sole trader, there is no intermediary. The contract exists directly between your business and the individual.
The relevant legislation for both income tax and National Insurance is:
- Income Tax (Pay As You Earn) Regulations 2003
- Social Security (Categorisation of Earners) Regulations 1978
- Social Security Contributions and Benefits Act 1992
- Social Security (Contributions) Regulations 2001
In these cases:
- The actual contract is assessed using employment status case law
- There is no hypothetical contract
- If the engagement is a contract of service, it is treated as employment
- Payments are treated as employment income
- PAYE and NICs must be operated on those payments
If you want to speak to us about limited company contractors and sole traders, and what they might mean to your business, book a free consultation with an expert.
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